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1. Theoretical Structure of Project Finance
An introductive chapter explaining theoretical fundamentals of project finance is
reported. In particular, this section would provide a general overview of definitions,
structure and features of Project Finance (Ch.1.1.). Afterwards, main subjects involved and
salient contracts between the part related to this approach are showed (Ch.1.2.).
1.1. Definitions and Characteristics
Project Finance is the long-term financing of legally and economically self-contained
(“ring-fenced”) project through a specific economic entity, that is the Special Purpose
Vehicle (SPV) or also known as project company whose only business is the project
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.
The SPV is created by sponsors, which are the investors who provide equity or other
financing for as subordinate debt. While, the project finance-based debt is provided by one
or more lenders. Apart from Sponsors and investors in general, the other possible financing
sources are public-sector grants and bonds issued. Usually, there is a high leverage ratio
(debt to equity), the project finance debt may cover 70-90% of the cost of a project
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.
The SPV isolates the initiative, the cash flows and the risks regarding the project. The
SPV and sponsors are two separated entities and the economic relation between them
depend on the type of the project finance. The project finance is said to be non-recourse
when lenders are satisfied only by the expected project cash flow as guarantee, and in case
6
Yescombe E.R. (2002), Principles of Project Finance, London, Academic Press.
7
Yescombe E.R. (2002), Principles of Project Finance, London, Academic Press.
of failure, they are paid by the assets value of project.
limited recourse to the assets of parent companies sponsoring the project. In this case
require additional guarantees. T
the assets quality. The limited recourse
request by lenders are increasingly
Risk identification and allocation is a key component of project finance
approach is founded on a security package, in fact, t
Project Company have the correct risk allocation among the subjects involved in the
project as objective. The optimal risk sharing follows the principle of
risk management
9
.
There is no such thing as “standard” project finance, the structure can be different
among various industry sectors and from
features. A simplified structure is showed by Fig. 1.
Fig.
Source: Yescombe E.R. (2002),
8
Morrison R. (2012), The Principles of Project F
9
In accordance with the principle, the subject’s aim is allocating risk to the parties who are most capable of
managing the specific risks or, where this is no possible, mitigating risks in other ways.
by the assets value of project. Otherwise,
the assets of parent companies sponsoring the project. In this case
require additional guarantees. The recourse is limited over the time, on the amou
limited recourse is the widely used in practice, but the guarantees
request by lenders are increasingly growing.
d allocation is a key component of project finance
s founded on a security package, in fact, there are contracts entered into the
have the correct risk allocation among the subjects involved in the
. The optimal risk sharing follows the principle of better know
There is no such thing as “standard” project finance, the structure can be different
among various industry sectors and from deal to deal and each of them
A simplified structure is showed by Fig. 1.
Fig. 1.: Simplified Project Finance Structure.
Yescombe E.R. (2002), Principles of Project Finance
e Principles of Project Finance, Burlington, Gower Publishing Company.
In accordance with the principle, the subject’s aim is allocating risk to the parties who are most capable of
risks or, where this is no possible, mitigating risks in other ways.
2
Otherwise, Lenders may have
the assets of parent companies sponsoring the project. In this case they
he recourse is limited over the time, on the amount and on
is the widely used in practice, but the guarantees
d allocation is a key component of project finance
8
. This financing
here are contracts entered into the
have the correct risk allocation among the subjects involved in the
better know-how in
There is no such thing as “standard” project finance, the structure can be different
deal to deal and each of them has its own unique
Principles of Project Finance.
Publishing Company.
In accordance with the principle, the subject’s aim is allocating risk to the parties who are most capable of
risks or, where this is no possible, mitigating risks in other ways.
3
Analyzing the general economic benefits brought by the project finance approach, it is
shown that it could be more efficient with respect to the traditional forms of corporate
financing. Some reasons support this argument.
Firstly, in project finance context, the financing is subordinated only to the projects
ability to generate cash flows
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. The cash flows should be able to repay debt and
remunerate capital invested at a rate consistent with the risk tied up with the venture
concerned. Thus, it does not depend on the soundness and creditworthiness of the sponsors.
The SPV’s ability to generate cash flows is initially weak in the project’s construction
period and growing stronger in the first year of operation. Once the project is completely
amortized, since the taxes begin to increase this growth slows down. After that, cash flows
pick up again, thanks to the progressive repayment of the debt results in fewer interest
payment. The cash flows are destined to the debt services at first, then to pay subordinate
debts (please refer to Ch. 1.2.1.) and dividends among sponsors.
Secondly, the project finance is generally faster than traditional forms with respect to
the frequency of projects meeting time schedules and frequency of project meeting
budgets.
Thirdly, it can be used to improve the return on the capital invested in a project by
leveraging the investment to a greater extent that would be possible in a traditional
corporate financing project
11
.
Lastly, this approach can reduces the cost of agency conflicts inside project companies
and the opportunity cost of underinvestment due to leverage and incremental distress costs
in sponsoring firms
12
.
The project has a finite life, based on the length of contracts, licenses or the reserves of
natural resources. Therefore, a project initiative has to be completely repaid at least by the
end of this life. Three phases can be distinguished
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:
• Initiation and Development. After the project conception, a bidding process
through the prequalification takes place, and a request for proposal (RFP) to the
prequalified bidders (also known as “invitation to tender”) follows it. Then, in
case of winning tender, lenders are founded by sponsors, the concession
agreement is signed and other contracts negotiated and at least signed in
10
Gatti S. (2008), Project Finance in Theory and Practice, London, Academic Press.
11
Nevitt P.K., Fabozzi F.J. (2000), Project financing, London, Euromoney Books.
12
Esty B.C. (2003), The Economic Motivations for Using Project Finance, Mimeo.
13
Yescombe E.R. (2002), Principles of Project Finance, London, Academic Press.
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preliminary form, equity and debt put in place. The end of this process is known
as “financial close” or “effective date”;
• Building. The greatest part of project risks are concentrated over this period. The
project funds are drawn down and the end of this phase is enshrined by the
project completion. This process close and the beginning of the next phase is
known as “commercial operation date” (COD);
• Operational. The completion of project is proved also with performance tests.
The project operates commercially and generates cash flows used to repay
lender’s debt and equity return.
Generally, the phases of project are related to the type of recourse: usually, during the
building period the project finance is limited recourse. The main reason is that, in case of
failure, the sponsors has to repay, through some guarantees, a certain percentage of debt.
Whereas, the operational phase is usually characterized by non-recourse. The reason
underlying the changing in type of recourse is the overcoming of the major part of risks
that are related to the project building phase.
In addition, the financing structure of the debt impose that the interests on debt start to
be capitalized when the lenders provide financing. The repayment of the debt is
subordinated to the beginning of the COD. Hence when the project generates cash flows,
these ones have to repay the debt.
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1.2. Subjects and Contracts Involved
A project financing operation involves many subjects. This section provides a
description of the main actors, their typically feature, their role in the structure of project
finance and contracts signed among them. In particular it is reviewed sponsors (Ch.1.2.1.),
project company (Ch.1.2.2.), lenders (Ch.1.2.3.), public authority (Ch.1.2.4.), off-takers
(Ch.1.2.5.), constructors (Ch.1.2.6.) and operators (Ch.1.2.7.). Since that, there is the
possibility that the same subject has a double role or that an actor does not take part in an
initiative, the project finance is not a standardized approach.
1.2.1. Sponsors
The equity investor(s) and owner(s) of the Project Company could be a single party, or
more frequently, a consortium of Sponsors. They provide equity or/and subordinate debt
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,
and assume the major part of the risks of project
15
.
Sponsors could have to design the project, then promoting that, and their role depend
on to the form of the project (non-recourse or limited recourse).
The investors have to offer priority payment to the lenders
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in order to obtain project
financing debt. In case Sponsor put in place only equity, they will receive their equity
return after lenders have been paid of the due amounts. If Sponsors use subordinate debt,
they could receive the interest over their subordinate debt during the senior debt repayment
(due to the lenders) but only if there is enough cash.
The literature define project initiative as an “off balance sheet” operation for sponsors
(while, the traditional corporate financing is defined “on balance sheet”). This concept
need to be clarified. When a company finances a new project off balance sheet (thus with
project finance), it means that that company isolate the new initiative in an ad hoc vehicle
company. Therefore, the financing sources do not result into the Sponsor’s balance sheet
but into the SPV once in order to avoid that the new project’s risks “contaminates” others
Sponsor’s assets. However, the question about if debt part of project financing sources has
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This type of debt is subordinated to other SPV's debts, included senior debt and bond. It produce benefits
to both SPV and Sponsor. It is less expensive than equity for SPV and, on the sponsors hand, it enhances
return on equity and avoid dilution, it provide tax benefits to their issuers and it is more flexible than equity.
15
Gardner D., Wright J., Project Finance, Ch. 12, HSBC, http://www.hsbcnet.com.
16
Yescombe E.R. (2002), Principles of Project Finance, London, Academic Press.
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to appear into balance sheet of sponsor is regulated by the International Accounting
Standard (IAS). The guidelines of these principles, in a nut-shell, say that sponsors who
have the control of the SPV has to indicate into balance sheet of their companies the
relative part of financial debt
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. Thus, it should be said “in-balance sheet” for the cases
mentioned. In fact, firms using project finance have a leverage ratio and debt/EBITDA that
seems not to be in “normal range”. Although this accounting rule, analysts have not to take
into account debt concerning the projects basket for a correct valuation of sponsors’
companies. The amount of debt that has to be subtracted from the total debt of sponsors’
firm depend on two factor: the phase of project and consequently the type of recourse,
knowing the relation showed in the previous chapter. For example, in case of corporate
valuation of sponsor’s firm that has a unique project in phase of building, in which has the
mid control (50%), an analyst has to take into account only half of debt regarding the
project.
The drawback of project finance for sponsors is that structuring and organizing such a
deal is much more expensive than the corporate financing option. The high cost are due to
the legal, technical, insurance advisor and monitoring cost. Moreover, the lenders are
expected to be paid so much in exchange for taking high risks.
On the other hand, project finance offers benefits. Sponsors, through this approach, may
have the access to financing sources that could not have in simple corporate financing. In
addition, as Tab.1. shown, the high leverage leads high return on equity (equity IRR) and
tax benefits because interest expenses are tax deductible unlike dividends to shareholders
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.
17
Principles can be viewed at the IAS website http://ec.europa.eu.
18
Corner B., Bodnar G.M. (1996) , Project Finance Teaching Note, Teaching note.
Low leverage High leverage
Project cost 1000 1000
a) Debt 300 800
b) Equity 700 200
c) Revenue from the project 100 100
d) Interest rate on debt 5% 7%
e) Interest payable (a x d) 15 56
f) Profit (c - e) 85 44
ROE (f / b) 12% 22%
g) Tax rate 30% 30%
h) After tax profit [f * (1 -
g)]
60 31
after tax ROE (h / b) 8,5% 15,4%
Tab. 1.: Example of Benefit of Leverage Investors Return.
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Project sponsors can be classified as industrial sponsors, who feel the initiative as
linked to their core business (often oil companies); public sponsors, who have the well-
being growth and social welfare their aim; contractor/sponsors, who develop, build or run
plant and are interested in participating in the initiative by providing equity and/or
subordinate debt; purely financial investors, who are attracted by the high return on equity
invested
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.
1.2.2. The Project Company
All the contractual and financial relationships in project finance have to be contained
inside the Special Purpose Company or Vehicle.
The Project Company cannot carry out any other business which is not part of the
project. The SPV may not always be directly owned by the Sponsor; for tax reasons the
Sponsors could use an intermediary holding company in a favorable country tax
jurisdiction.
If there is more than one Sponsor, once the Project company (that is responsible for the
project) has been set up, the Development Agreement previously signed by the Sponsors is
superseded by a Shareholder Agreement that covers issues such as: percentage share
ownership, procedure for future equity subscriptions, voting of shares at the annual general
meeting, board representation and voting, provisions to deal with conflicts of interest (e.g.,
if the EPC Contractor is a Sponsor, participation in board discussion or voting on issues
relating to the EPC contract are not allowed), appointment and authority of management,
distribution of profits and sale of shares by Sponsors.
It's important to specify that the operation of the project could be carried out by Project
Company personnel or by a third-party operator under an O&M contract.
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Yescombe E.R. (2002), Principles of Project Finance, London, Academic Press.
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